Momentum investing – betting on the persistence of price trends in the short to medium term — has captured the crowd’s attention in recent years.
Consider, for instance, the strong growth in ETF assets in the niche. The first fund launched a bit more than five years ago; today, there are dozens of momentum ETFs, collectively holding nearly $15 billion in assets, according to etfdb.com. That’s still a small piece of the total ETF pie, but the strategy’s allure could keep growth bubbling for years to come. What should investors expect? Does the rising interest in momentum raise concerns about the strategy’s expected return? For some insight, The Capital Spectator asked Wesley Gray at Alpha Architect, a wealth manager near Philadelphia. Gray, who previously worked as a finance professor, is an obvious source for discussing momentum. In addition to managing variations of momentum-based portfolios for clients, he and his team have written extensively about the strategy at AlphaArchitect.com, a popular investing blog. Gray is also the co-author of Quantitative Momentum: A Practitioner’s Guide to Building a Momentum-Based Stock Selection System
Why does momentum persist? It’s been identified in the literature for decades and traders have been using it for much longer in one form or another. Most return anomalies are arbitraged away or turn out to be data-mining illusions. Momentum seems to be different. Why?
This is a debate that still rages in academic circles, but it boils down to a mix of fundamental risk and mispricing that is tough to arbitrage away. Fundamental risk is easy to understand — higher risk generally earns higher returns in a competitive equilibrium. Mispricing is a bit trickier.
If the mispricing is easy to exploit — i.e., you can generate 2-plus Sharpe ratio strategies by exploiting momentum — one can be sure the highly leveraged computer geeks at fast-moving hedge funds and proprietary trading shops will take care of the mispricing. But what if trying to exploit momentum mispricing is akin to eating a hand grenade on occasion? Well, it turns out that strategies designed to “arbitrage” momentum profits away can be incredibly volatile and suffer huge drawdowns — not exactly low-risk-easy-to-leverage trading strategies that the 200 IQ types look forward to exploiting.
Long story short, sometimes even the best evidence-based active investment strategies can create a formidable challenge to investors seeking to exploit them. It’s a kind of quid pro quo: in order to access the potential gain, you must willing to accept the potential pain.
Could momentum be the most epic data-mining result in all of finance? Sure. Could it vanish in the future? Possible. However, if we believe that momentum stocks are 1) naturally riskier and 2) driven by systematic mispricing that is costly to “arbitrage,” we can expect momentum investing to work in the future.1
There’s been strong growth in momentum-focused strategies and investment products in recent years. Is there a capacity limit for the strategy? If so, are we near that limit?
Jack Vogel, one of my business partners, recently published a long piece called, “Factor Investing and Trading Costs,” which addresses this question in great detail. The short answer, yes, the capacity on momentum strategies is limited. Some folks argue it’s anywhere from $5 billion to $300 billion-plus in capacity.
On the question of “are we near the limit,” I’d guess that we are still a ways off, based on a few things. First, most so-called momentum funds are closet-indexers so their actual momentum exposure if fairly limited even with a large amount of assets under management. Also, David Blitz [Robeco Asset Management] highlights that the ETF market as a whole hasn’t taken a dramatic momentum bet.
At some point momentum, or any strategy for that matter, could suffer from too many dollars chasing too few returns. That said, given the relatively poor performance of momentum over the past decade, I’m not convinced there are huge swaths of short-term-performance-chasing investors looking to dive into stock momentum strategies — I think most [performance-chasing] investors have turned to things like cryptocurrency speculation.